15 April 2007

Germany, U.S. Split Over Need for Hedge Fund `Code of Conduct'

“We should move forward in developing a strong case for a benchmark of best practices” that culminates in a code, Bundesbank President Axel Weber told a panel at the International Monetary Fund today. Robert Steel, the U.S. Treasury's top finance official, said in an interview that ``sounds like a policeman and that's not what I'm into.''

Germany, which holds the G-7 presidency this year, is leading a euro-region push for tougher oversight amid concern growth of the US$ 1.5 trillion hedge fund industry poses a threat to financial markets and the world economy. The U.S. and the U.K. prefer relying on investors and lenders to monitor risks.

G-7 officials, including Steel, met today with about a dozen representatives of hedge funds in Washington. The group is compiling information on the industry in preparation for discussions by leaders at a summit in Germany in June.

The meeting featured talks on “risk management, current hedge fund and private-equity regulations and disclosure issues, including a discussion of best practices,'' the U.S. Treasury said in a statement.

The structure of hedge funds allows managers to participate substantially in investment returns. That creates an incentive to make leveraged bets with borrowed funds, a tactic that can stoke returns and magnify loses. The funds are back in the spotlight after Amaranth Advisors LLC, based in Greenwich, Connecticut, lost a record $6.6 billion in September from bets on natural gas.

European officials said during the meetings of the G-7, IMF and World Bank this weekend that they were concerned about letting lenders to hedge funds police risks and leverage.

Prime brokers including Goldman Sachs Group Inc. and Bear Stearns Cos. earn fees from loans to hedge funds. International regulators are now gathering information on how margins are set for those loans.

“Competition amongst prime brokers is intense and there are plenty of signs that margins have been lowered in recent times,'' Mario Draghi, governor of the Bank of Italy, said today. “There are signs that credit standards have been weakened and that the quality of the collateral that's being accepted is actually decreasing.''

German Deputy Finance Minister Thomas Mirow, who co-chaired today's G-7 meetings with Tim Adams, the U.S. Treasury undersecretary for international affairs, said April 13 “it can't be ruled out that they're reducing their risk awareness in order to win business,'' referring to banks.

G-7 finance ministers and central bank governors said after talks in Washington two days ago that they will “continue to monitor'' the implication of the role of funds.

“There's a wide difference of views on what to do,'' said Draghi. A code of conduct is one of the options being discussed and it's ``not at all clear'' that hedge funds would reject it, he said. Bank of France Governor Christian Noyer said today that a code could be “absolutely compatible'' with free markets.

While there are no “acute'' signs of increased risks of a financial crisis triggered by hedge funds, there is an awareness “risks may be building up,'' Mirow said today. He cited an abundance of liquidity, continued strong lending by banks and the increasing securitization of loans -- some of the factors that American officials say makes a crisis less likely.

U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke have advocated a “light regulatory touch,'' noting that hedge funds have deepened liquidity in financial markets, spurred innovation and helped diffuse risks. Investors in them are sophisticated and the banks that lend to them have an interest in ensuring that excessive risks aren't taken, U.S. officials say.

“Because hedge funds deal with highly sophisticated counterparties and investors, and because they have no claims on the federal safety net, the light regulatory touch seems largely justified,'' Bernanke said in an April 11 speech in New York.

Paulson, the former head of Goldman Sachs, revisited the U.S. government's approach to monitoring hedge funds in February, opting for a set of principles to guide hedge-fund managers and other market participants.

“I care about behavior,'' said Steel, who worked at Paulson's side at Goldman Sachs for three decades. “We've got the right issues with the President's Working Group guidelines and people are discussing those.''

Mirow said in an interview today that he was still “optimistic that we can reach joint conclusions in the course of this debate.'' He added that Germany isn't asking for regulation per se – “neither light nor heavy.''

Ministers want to learn from hedge funds how risks are assessed and how to cope with them, especially through more disclosure and transparency, Mirow said. “There are differences of opinion as to who should disclose what and how we can get companies to disclose information.''

“This is a fact-finding exercise so ministers can get a clearer view on how hedge funds operate and we can get a view into their thought process,'' said Gordon McAra, a spokesman for the London-based Alternative Investment Management Association, whose executive Florence Lombard attended the meeting. “It's a two-way dialogue,'' he said before the meeting.

Hedge funds have more than tripled since the Fed organized a bailout of Long Term Capital Management LP in 1998 to prevent billions of losses rippling through Wall Street.

Swiss National Bank governing board member Philipp Hildebrand said ultimately governments would have to reach a consensus or hedge funds will move to the nations with least oversight. “This will only work if internationally coordinated or it will run into competition problems,'' he said.

By Kevin Carmichael and Rainer Buergin

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